Regulatory Reform and the Fed

Early last summer, the Obama administration proposed a sweeping revision of U.S. financial regulation. Among its notable features are the elevation of the Federal Reserve to the role of primary financial regulator and the creation of a Financial Services Oversight Council to monitor so-called systemic risks, i.e., those exposures that risk a cascading series of failures based on the collapse of one entity.

A number of observers (including former Fed Chairman Paul Volker) have focused on the notion that the proposal will create moral hazard by codifying certain institutions as "too big to fail," concerns that were not assuaged by Treasury Secretary Tim Geithner's recent Congressional testimony. However, my concern is that the proposals ultimately will be ineffective in managing risks to the financial system. If this turns out to be the case, the resulting complacency will create an environment ripe for new problems.A poorly conceived and structured regulatory regime risks giving market participants unjustified confidence that systemic exposures are under control, even as the financial system's risks could actually be growing. (This brings to mind the Long Term Capital Management crisis in 1998, in which a fairly obscure firm had positions large enough to threaten the viability of the financial system.) The events of the past few years show how dangerous complacency on the part of managers and regulators can be.

A major problem with the proposal is that it seeks to rigidly identify firms that pose systemic risks, without a sound method of evaluating future changes in the marketplace. A solid regulatory regime requires the same elements that characterize strong risk management at the firm level, including flexibility in how risk is measured and managed and an understanding of how markets adapt and evolve. Good risk managers also understand that analytical devices such as value-at-risk are merely useful tools in a broad and comprehensive monitoring program. The proposed structure for managing systemic risks is the market equivalent of "fighting the last war," rather than creating a structure robust and flexible enough to meet future challenges.

History also suggests that financial firms will work diligently to beat a carelessly constructed management and/or regulatory structure, particularly when their compensation is at issue. The financial markets are filled with technically brilliant people who nonetheless require adult supervision; a corollary to Murphy's Law stating that "nothing is ever foolproof because fools are so ingenious" certainly applies here.

An equally critical weakness in the proposal is the elevation of the Fed to the role of primary regulator. In my opinion, giving the Federal Reserve regulatory primacy risks further politicizing monetary policy. The Fed is already the target of significant criticism over its policy and regulatory failures since 2002-2003, and has only added to its burdens by volunteering for the politically-charged task of overseeing bankers' compensation. By plunging so deeply into activities carrying political overtones, the Fed will find it increasingly difficult to effectively manage monetary policy going forward, as well as execute the "exit strategy" of withdrawing the extraordinary measures of the last few years in a non-disruptive fashion. While Ron Paul's End the Fed movement is currently an amusing curiosity, a dangerous chorus could grow with a new round of financial market problems.

The Fed's credibility is a precious asset that must not be squandered or compromised. I believe that a better structure would be to relieve the Fed of much of its responsibilities for regulatory oversight and make the Office of the Comptroller of the Currency (a unit of the Treasury) the primary regulator. This would reinforce the Fed's independence in pursuing monetary policy, while removing many of the ambiguities and loopholes that caused the regulatory failures of the past few years.

Bill Berliner is a consultant based in Southern California. His Web site is www.berlinerconsulting.net